HAPPY DRAGON RESTAURANT LTD v. DIRECTOR OF LANDS

IN THE LANDS TRIBUNAL OF THE

HONG KONG SPECIAL ADMINISTRATIVE REGION

Lands Resumption Application No. 17 of 2006

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BETWEEN

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JUDGMENT

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Background

1.  On 30 March 2010, the Court of Appeal in the Judgment of CACV 201 of 2009 allowed the Applicant’s appeal and set aside this Tribunal’s order dated 28 April 2009.  The Court of Appeal further ordered that the Applicant be awarded compensation for disturbance in the sum of $5,337,969 with interest and that the issue of quantum under the extinguishment claim be remitted to this Tribunal for determination.  The present hearing before us is for the determination of the said issue.

2.  The Court of Appeal has already decided that the resumption did cause total extinguishment to the Applicant’s restaurant business operated under the name of Sun Rise Court Restaurant at the affected premises.  It is common ground that the restaurant commenced business from December 2003 and ceased business at the end of February 2005.  Our task is therefore only to determine the quantum of compensation payable to the Applicant.

Differences between the parties

3.  The Applicant in its final submission conceded to adopt the approach of the Respondent’s expert witness, Ms. Mary Tam, albeit with a few variations, and claimed for a total loss of goodwill of $13,907,302.  On the other hand, the Respondent submitted that the Tribunal should adopt the assessment of Ms. Tam and award a sum of $2,235,000 to the Applicant as the fair compensation on the extinguishment of business basis.

Evidence from the experts called by the parties

4.  We have previously heard evidence from several experts called by the parties at the original trial.  During this hearing, both parties relied on the previous evidence adduced at the trial and the review of this case.  Because of the length of time elapsed between the original trial and this hearing, we have to go through the Bundles of documents, the parties’ submissions and the transcripts, where necessary, to recall our memories of the evidence.

5.  Several methods have been used by the parties’ experts in the estimation of the loss of goodwill due to the extinguishment of the Applicant’s restaurant business.  The Applicant’s valuation expert Mr. YS Wong used his “Investment Method” arriving at an estimate of $40,455,300 (Bundle F/1528).  The Applicant’s accounting expert, Mr. YM Cheung used two different methods of valuation: (i) the P/E (Price/Earnings) Ratio Method commonly used in valuing shares of listed companies and (ii) the DCF (Discounted Cash Flow) Method commonly used in valuing projects where revenues and costs were incurred at different points of time during the project period.  Mr. Cheung estimated the compensation sum to be (i) $20,460,000 using the DCF Method, and (ii) in the range of $17.5 Million to $24.5 Million using the P/E Ratio Method. 

6.  On the other hand, the Respondent had only one expert witness, Ms. Tam, giving evidence on the valuation of the loss of goodwill on the extinguishment of business basis.  Ms. Tam used the Multiplier method in estimating the loss of goodwill.  She first estimated the sum to be $3,520,360 (Bundle D/306).  In her supplemental report (Bundle D/340), she revised the sum to $2,977,606 after adopting the 12 months’ data instead of the accounting figures for the entire period of 14.5 months.  This estimate was further reduced to $2,235,000 (Exhibit R14, at Bundle F/1598) after Ms. Tam opined that interest to shareholder for the loan provided to the Applicant in the sum of $300,000 should be deducted before arriving at the profit before tax.  She calculated the loss of profit, after the adjustments, to be $745,034.  Applying a multiplier of 3 to this profit estimate, it gave a sum of $2,235,104 which she estimated as the total loss of profit that should be compensated to the Applicant on the basis of total extinguishment of business.

The Applicant’s claim

7.  The Applicant in its written submission dated 26 May 2011 filed into this Tribunal before the hearing submitted that the Applicant had decided not to use the valuation of Mr. YS Wong, but adopted the valuation of Mr. YM Cheung, in the sum of about $20 Million, and that the valuation of Ms. Tam should be rejected.  The Applicant was of the view that Mr. Cheung’s valuation accorded with the P/E Ratio Method in adopting 8 years and 9 months (being the unexpired term of the lease) as the multiplier.   The Applicant further submitted that “alternatively and in any event, the base figure for annualized profit after tax should be $1,979,213 (taking into account of loss revenue) or $1,461,030 times the remaining lease term and then applying a discount factor for the early receipt of compensation.”

8.  However, the Applicant in the final oral submission submitted that the Applicant was prepared to give a concession by adopting the methodology of Ms. Tam, including her latest version of valuation (see Exhibit R14, at Bundle F/1598) of using the accounting figures for the period from 1 January 2004 to 31 December 2004. Of course, these figures were in turn based on the accounting figures of the Applicant’s business from its set of audited accounts during its history of operation (i.e. from commencement to cessation).  However, the Applicant submitted that notwithstanding the concession to use Ms. Tam’s approach, 4 outstanding issues remain.  They are: (1) whether the pro-rata amount of “administrative fee”, in the sum of $380,774 x 12/14.5 months, should be included as other revenue of the business; (2) whether the pro-rata amount “sundry income”, in the sum of $347,613 x 12/14.5 months should also be included as other revenue of the business; (3) whether “interest to shareholder”, estimated by Ms. Tam to be $300,000 should be deducted as cost before arriving at the “profit before tax” and (4) whether “loss revenue due to impact of expected resumption”, estimated by the Applicant to be $512,183, should be added back to the accounting figures before arriving at the “normalized annual profit”.  In its final submission, the Applicant produced a computation sheet (Exhibit A15) giving the estimate for the loss of goodwill in the sum of $13,907,302.

9.  The Applicant’s computation is summarized as follows:-

Gross Profit		$13,845,307.74
Add-

	(1)	Administrative Fee	$380,774.00
	(2)	Sundry Income	$347,613.00
	Total		$728,387.00
	Pro-rata total (12/14.5 months)		$602,803.00

Gross Profit after adjustment		$14,448,110.74
Less-
Total fixed & variable cost after adjustment		$12,642,235.31
Profit before tax		$1,805,875.43
Taxation (at 17.5%)		$316,028.20
Profit after tax		$1,489,847.23
Add-
Loss revenue due to impact of expected resumption		$512,183
“Normalized annual profit”		$2,002,030.23
Multiplier		x 6.9466
Applicant’s estimated Loss of Goodwill		$13,907,302

The Respondent’s case

10.  The Respondent in its final submission sought to submit that it would be unreasonable to award the Applicant compensation on extinguishment of business in the sum of about $14 Million.  However, as this Judgment is only concerned with the assessment of the quantum of compensation, it would be inappropriate to simply compare, as submitted by the Respondent, the final estimated sum with the short duration of the business before its cessation or the cost of setting the company in starting the restaurant business.  In the final analysis, the Respondent relied on the evidence of Ms. Tam given at the previous hearings, and disagreed with the adjustments made by the Applicant. 

The Tribunal’s adopted methodology

11.  Having gone through the experts’ evidence and the parties’ submissions, we agree to adopt the methodology used by Ms.Tam.  Although the Applicant stated in its written submission that it adopted the methodology of Mr. Cheung, as the Applicant had conceded to adopt the methodology of Ms. Tam in the final oral submission, we shall not deal with this issue of methodology as an outstanding issue between the parties in great details in this Judgment. 

12.  However, we would like to put on record that we do not share with Mr. Cheung’s view that it is appropriate to use the P/E Ratio Method because (1) there were substantial differences in terms of the values of the subject business and a listed company both in terms of the differences in sizes and numbers of restaurants, (2) the differences in the number of years’ of past track records of the restaurants owned by a listed company and the very limited period of operation of the subject business which had only one set of audited accounts, and (3) a listed company obviously fetch a different set of P/E ratio simply because the liquidity of an investment in such a company is so much different than investing as a shareholder in the Applicant’s business.  As for the DCF Method, we also think that this is not appropriate because the Method is generally used when the project period is long and different revenues and expenditures are generated / incurred at specific points of times.  Given the large number of assumptions used in Mr. Cheung’s DCF Method, we do not find that it is appropriate to use that Method in preference to the usual Multiplier (or Years’ Purchase) Approach after a “normalized annual profit” for the extinguished business is assessed.  As often the case, and in this case, the “normalized annual profit” is based on the actual set of audited accounts which, apart from certain outstanding issues, are generally agreed by the parties.  Hence, the uncertainties of using the Multiplier Approach can be reduced to a minimum.

13.  Below, we will first determine the issues between Ms. Tam and the Applicant in estimating the “normalized annual profit” of the Applicant’s restaurant business, before we turn to the thorny issue of estimating the “Multiplier”.

Administrative fee

14.  The Applicant submitted that the Administrative Fee of $380,774 for the whole period of some 14.5 months shown in the audited accounts of the Applicant should form part of the income of the Applicant, in calculating the “normalized profit”.  This sum refers to, according to the Notes to the Financial Statement (Bundle D/286), “income being providing man-power, management support, accounting support, etc. to a related company, Bright Dragon Properties Limited.”  On the other hand, the Respondent, relying on Ms. Tam’s opinion submitted that this sum should be deducted from the total income of the Applicant in the relevant period.  We agree with the Applicant that this item should form part of the income of the Applicant’s business. There is no dispute that the Applicant will be deprived of receiving this income annually following cessation of the business which stand on the resumed premises.   

15.  In following the approach of Ms. Tam of using the actual calendar year’s accounting figures, we calculate the administrative fee on a pro-rata basis ($380,774 x 12 / 14.5 months) and add it back to Ms. Tam’s adopted gross profit of $13,845,307.74.  This is the same as shown in the Applicant’s computation at paragraph 9 above.

Sundry income

16.  Similarly, the Applicant submitted that the Sundry Income of $347,613 for the whole period of some 14.5 months should form part of the income of the Applicant.  This sum refers to, according to the Notes to the Financial Statement (Bundle D/286), “tips received from customers and contributions from suppliers during restaurant openings and mid-autumn festivals.”  The Respondent also relied on the opinion of Ms. Tam and submitted that this item should be deducted.  We do not have the break-downs of the tips and contributions from suppliers.  However, we agree with the Applicant that upon extinguishment of business, it would cease receiving the tips and contributions from suppliers for the mid-autumn festival and presumably for other festivals as well.  We therefore agree that this item should be added back to the income of the Applicant’s business.

17.  In following the approach of Ms. Tam of using the actual calendar year’s accounting figures, we calculate the administrative fee on a pro-rata basis ($337,613 x 12 / 14.5 months) and add it back to Ms. Tam’s adopted gross profit of $13,845,307.74.  Again, this is the same as shown in the Applicant’s computation at paragraph 9 above.

Interest to shareholder

18.  In the Applicant’s audited accounts, an interest-free loan of $5,843,728 was provided to the Applicant by its shareholders.  The Applicant submitted that its witness had confirmed that the shareholders wished to be remunerated by the distribution of profits in the Applicant’s business, instead of charging the loan at market rate.  Therefore, the Applicant said that it would be wrong for Ms. Tam to allow a deduction of $300,000 as an “interest to shareholder” item.  We agree with the rationale and the method adopted by Ms. Tam in attempting to find the “normalized annual profit” of the business.  The test of the rationale of this item will be easily understood if for example, the shareholder of the Applicant had provided a much bigger interest-free loan of say $20 million to the Applicant so that in addition to the use of a portion of this loan (about $6 million) for running the business, the Applicant had put the remaining sum of about $14 million in fixed deposit in the bank thereby earning interest.  Are we saying that under similar circumstances, no deduction for interest payable to the lender of the $20 million loan (even though the lender was the shareholder) should be allowed in attempting to arrive at the “normalized annual profit” of the Applicant?  The obvious answer is no.  Otherwise, the Applicant’s accounts will give an inflated amount of profit because the applicant’s income includes the interest from this loan.  Hence, we are of the view that similar reasoning applies in the present case.  That is, in having the advantage of not being required to pay any interest on a loan of $5,843,728 from a related party, the Applicant would inflate the profit of its business.  In order to find the “normalized profit” of the Applicant’s business, we agree with Ms. Tam that the interest of that loan at market rate should be deducted.  Ms. Tam estimated this in the annual sum of $300,000.  The Applicant only disputed this sum in principle and did not suggest that this estimate was wrong, nor did it provide any other estimate.  As we have decided above that the deduction was necessary, we shall therefore adopt Ms. Tam’s figure in the computation of net profit later.

Loss revenue due to impact of expected resumption

19.  In the final written submission, the Applicant submitted that the base figure for the “normalized annual profit” after tax should be $1,979,213 (after taking into account of loss revenue) or $1,461,030 (without taking into account the loss revenue).  By loss revenue, the Applicant claimed that the “normalized annual profit” was lower than normal because the Applicant’s business was affected by the threat of resumption.  The Applicant claimed that “there was additional loss of revenue due to the resumption rumour as customers were not placing orders for birthday banquets and wedding celebrations, festival and other events.”  The Applicant’s conclusion was based on Mr. YM Cheung’s Report at Bundle D/1011-1012 and his evidence at Bundle E2/1313L-1315A. 

20.  On the other hand, the Respondent argued that the Applicant failed to show that the loss in terms of reduced turnover was due to the resumption rumour.  The Respondent adopted to use Ms. Tam’s adjusted figures, which was based on the actual 12 months’ accounting figures plus adjustments.

21.  Having compared the figures in details, we do not agree to use the Applicant’s adopted figure of $1,979,213 reflecting its estimated loss revenue.  Also, we prefer to use the actual 12 months’ figures, without the adjustments by Ms. Tam.  Frankly, the Applicant had only a short history and record of business turnover.  We could not simply compare two respective months and come up to a conclusion that the lower figure for the latter year was due exclusively to a certain factor (i.e. the resumption rumour).  The relationship is too weak.  There may well be other reasons we could think of.  For example, it could likely be the case that when a restaurant opens its business, particularly in a traditional neighbourhood, it could draw interests in terms of wedding and other banquets because some patrons would like to enjoy the brand new or near brand new facilities.  This may then artificially raise the turnover and the profits of the first few months of operation of the new business.  Therefore, we find that it would be more reasonable to simply adopt the actual 12 months’ accounting figures without adjustment one way or the other.  This we shall apply in the estimation of the “normalized annual profit” of the Applicant below.

Estimate of Multiplier

22.  Although the Applicant conceded to adopt Ms. Tam’s methodology, the Applicant did not agree to use her adopted Multiplier of 3. Instead, the Applicant submitted to use a discounting factor after having regard to the remaining 8.75 years’ lease term (based on that of the restaurant’s lease) and the then prevailing best lending rate of 5%.  The Applicant calculated the Multiplier to be 6.9466.  On the other hand, the Respondent continued to stick to the Multiplier of 3 as opined by Ms. Tam.

23.  The choice of an appropriate multiplier for estimating the amount of loss of profits (or generally referred to as the loss of goodwill) as compensation sum payable to the aggrieved owner or tenant on extinguishment of business, as a result of compulsory acquisition of property in Hong Kong, has been a difficult issue.  Unlike other parameters used in valuation of landed interests or even valuation of plant and machinery, there is a dearth of direct market evidence of business goodwill.  Profitable businesses are seldom changing hands as going concerns and even if there are transactions, they are seldom reported as publicly available market information.  Unlike property transactions, there is also no statutory requirement for the business to disclose the transaction and no central registry (like the Land Registry) for the registration of these transactions.  Although there is a statutory requirement for every listed company, under certain conditions, to disclose its business transaction, very often the transactions are very complicated so that it is difficult even for the veteran analyst to conduct its analysis, let alone an average valuer in the market.

24.  For the above reason, as far as we know, there is no market evidence similar to Schilt Table (as that used in the landmark Shun Fung case in Hong Kong) ever published by reputable market analyst in Hong Kong.  Therefore, in applying directly the figures from the Schilt Table used in the US and using the valuer’s adjustments to reflect the differences between the environment in US and Hong Kong, and also the differences in the nature of business and time, the adjustments between different experts are often very substantial.  This we find is a virtually futile exercise.

25.  Hence, in this case, we find that it is appropriate to estimate the discounting rate from the first principle.  The Applicant submitted that as Ms. Tam had adduced evidence that the then prevailing Best Lending Rate was 5%, it would be appropriate to use 5% in calculating the “Multiplier” (or the Years’ Purchase, the term for the factor of sum of amount of $1 per annum at x % for y years).  The Respondent did not elaborate its objection except to re-confirm that the Multiplier of 3 (as a lump sum figure opined by Ms. Tam) was more appropriate.  We do not agree with the Applicant that the “normalized annual profit” should be discounted at the Best Lending Rate prevailing at the time of resumption.  First, it is very unlikely that the Applicant, or any similar business, could borrow money at the Best Lending Rate at that time.  Second, it is also unlikely that the “normalized annual profit” of the Applicant would be discounted by the Best Lending Rate, should there be a buyer for it in the market.  The likelihood of receiving the “normalized annual profit” is so much more risky that it would be absurd to suggest that any buyer would pay for it at a price arrived at by discounting the sum at the Best Lending Rate.  We find that it would be more appropriate to adjust, at the least, the extra risk by adding a few percentage points.  We think that adding 4% is a very conservative estimate.  Thus, we shall adopt this assumption below.

26.  The Applicant submitted that the “normalized annual profit” should be applied to the remaining lease of the Restaurant, ignoring the shorter ancillary leases for the BBQ shop and the staff quarters.  On the other hand, the Respondent said that as the Applicant used to claim that the Applicant’s business was an “integrated” business, it would not be reasonable to use the remaining lease of the Restaurant as to be the period over which the business should be compensated for the loss of “normalized annual profit” following its extinguishment.  We find that although the integrated business argument has not been accepted by the Court of Appeal as a pre-requisite of the Applicant’s claim of loss of profit on extinguishment of business, it is trite law that the Applicant could not assume that the expired leases for the BBQ shop and the staff quarters could be renewed.  We think that these would have an effect on the “normalized annual profits” for future years as additional rents would likely have to be paid for leasing similar accommodation elsewhere.  For this reason, we find that it would be reasonable, in trying to construct a discounting factor, to add an extra 1% risk factor to reflect the shorter duration of the 2 ancillary leases and the consequential effects on the net “normalized annual profit”.

27.  Summing up, we start from the Best Lending Rate of 5% and add on top of it additional percentages to reflect (i) the more risky nature of the “normalized annual profit” and (ii) the shorter duration of the 2 ancillary leases.  We opined that it would be reasonable, at the least, to add 4% and 1% respectively, for these two elements.  Hence, we come up with a discounting rate of 10%.  Using the mathematical formula for Years’ Purchase, we arrive at the factor of 5.6568 as being the Years’ Purchase for 8.75 years at 10%.  We shall adopt this factor in the computation below.

Tribunal’s estimate of the Loss of Profit on extinguishment of the Applicant’s business

28.  Following the approach of Ms. Tam which has since been accepted by the Applicant as the method to be used in this case, and applying our decisions on the 4 outstanding issues between the parties, we have set out the Tribunal’s computation of the valuation of the loss of profit of the Applicant, on extinguishment of is business, as follows:-

Gross Profit		$13,845,307.74
Add-

	(1)	Administrative Fee	$380,774.00
	(2)	Sundry Income	$347,613.00
	Total		$728,387.00
	Pro-rata total (12/14.5 months)		$602,803.00

Gross Profit after adjustment

$14,448,110.74

Less-
Total fixed & variable cost after adjustment	$12,642,235.31
Interest to Shareholder	$300,000.00

Total fixed & variable cost after adjustment	$12,942,235.31
Profit before tax	$1,505,875.43
Taxation (at 17.5%)	$263,528.20
Profit after tax (=“Normalized annual profit”)	$1,242,347.23
Multiplier (Years’ Purchase at 10% for 8.75 years)	x 5.6568
Estimate of the Applicant’s Loss of Profit on extinguishment of the Applicant’s business	$7,027,709.81
Rounded to	$7,027,710

Order

29.  Thus, we order that compensation for extinguishment of the Applicant’s business in the sum of $7,027,710 be paid to the Applicant.  The matters of professional fees, interest and costs shall be adjourned to a date to be fixed, with liberty to apply for any other ancillary and consequential matters.